Tuesday, September 17, 2013

Financing the Federal Government with Inflation-Protected Securities

In 1997, the U.S. Treasury made the contentious decision to begin issuing Treasury inflation-protected securities (TIPS). Treasury Secretary Robert Rubin proposed the issuance of these inflation-linked securities as a way to reduce the government's borrowing costs and increase the national saving rate, remarking:

"Helping the economy and raising incomes requires increasing productivity, and the saving rate is central to that objective. The initiative we are announcing today has the potential of raising our national saving rate as well as reducing the cost of capital to the federal government. Today we are announcing our intention to issue securities that will offer investors protection against inflation. Americans' retirement savings in their pension plans or their own IRAs can have inflation protection, which can help ensure their retirement security...

We believe these bonds will offer savers value-added in the form of protection against inflation, plus a real rate of return backed by the full faith and credit of the United States, and in return for offering that value-added, over time the cost of financing to the federal government will be lower than it otherwise would be...This is a common sense approach to government and an excellent example of government reinvention -- protecting Americans from inflation with an innovative investment method, and saving them money as taxpayers by holding down borrowing costs."

First, why might we expect TIPS to hold down borrowing costs in theory? Nominal bonds expose investors to inflation risk, so their yields presumably contain an inflation risk premium; by issuing indexed bonds, the Treasury can avoid paying the premium. John Campbell and Robert Shiller pointed out in 1996 that the magnitude--and even the sign--of the inflation risk premium was unknown. How could the inflation risk premium possibly be negative? According to the classic text on asset pricing by John Cochrane,

"All assets have an expected return equal to the risk-free rate, plus a risk adjustment. Assets whose returns covary positively with consumption make consumption more volatile, and so must promise higher expected returns to induce investors to hold them. Conversely, assets that covary negatively with consumption, such as insurance, can offer expected rates of return that are lower than the risk-free rate...You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

In short, the inflation risk premium does not depend directly on how uncertain or volatile inflation is. What matters for the inflation risk premium is how future inflation covaries with future consumption (alternatively, with the stock market), and that is not obvious. In 1996, Campbell and Shiller estimated the premium by several different methods and came up with an estimate of 50 to 100 basis points for a five-year zero-coupon nominal bond: in short, non-trivial savings for the government. These anticipated savings were part of the reason why the Treasury began issuing TIPS.

Why then, in 2008, did the Treasury Borrowing Advisory Committee recommend that TIPS should play a smaller role in meeting future financing needs? A member of the committee "estimates that the cumulative cost of the TIPs program to the Treasury since inception, when comparing the total expense relative to nominal bonds issued at a similar time, approaches $30 billion with the bulk of that cost a direct result of significantly higher inflation than estimated by the markets 'breakeven' level when issued." They attribute part of the cost to a liquidity cost, since TIPS are less liquid than nominals so investors must be compensated for the lower liquidity. They point out that the first factor--higher realized inflation than breakeven inflation--needn't necessarily continue. I would also point out that TIPS could gain liquidity over time as the TIPS market develops further, but the Committee's recommendation would very likely have reduced TIPS' liquidity.

An academic study in 2010 supports the view of the Treasury Borrowing Advisory Committee. In "Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle," Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig estimate that "On average, the U.S. government has to levy $2.92 more in taxes, in present discounted value, to repay $100 of debt issued if the debt is indexed rather than nominal." They add that, in issuing TIPS, the government gives up a valuable fiscal hedging option. Fleckenstein et al. say that "To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds represents the largest arbitrage ever documented in the ﬁnancial economics literature."

Jens Christensen and James Gillan (2011), in contrast, say that the Treasury has benefited overall from using TIPS. There are two main premiums to consider: the inflation uncertainty premium and the liquidity premium. The former can help the government lower its borrowing costs by using TIPS, and while the latter can raise its borrowing costs. Both premiums can vary over time. Christensen and Gillan attempt to quantify the size of each premium and construct a liquidity-adjusted inflation risk premium. They come up with a range of estimates, and the most conservative is plotted below. The fact that it is, on average, positive (and less conservative estimates more obviously positive) supports Treasury's continued use of TIPS. I find their results fairly convincing, particularly in light of another study

Source: Christensen and Gillan (2011)

Another study, by William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer (2009) also comes out in support of TIPS as a cost-effective form of government financing. Their estimates of the inflation risk premium by maturity of issue are in the table below. They find that the liquidity compensation was around 200 basis points in 1999 but has since fallen drastically to well below 50 basis points. The positive risk premium and low liquidity compensation in combination imply cost savings for the Treasury.

In my interpretation, the balance of evidence supports the idea that TIPS are mildly cost-effective, or at least not cost-increasing, for the Treasury. The government's borrowing cost is not the only factor to consider when evaluating the net effect of TIPS. Rubin, remember, suggested that TIPS would increase the nation's saving rate and in turn increase productivity. John Campbell and Robert Shiller listed other potential upsides and downsides to TIPS in their 1996 "A Scorecard for Indexed Government Debt." I'll discuss some of these other issues in future posts.

23 comments:

Really looking forward to this series, Carola. I hope you'll also touch on Shiller's advocacy of TIPS as a way to encourage greater use of inflation-protected debt contracts in the private sector, as well as Chile's experience with the Unidad de Fomento.

Thanks, I was definitely planning to discuss Shiller's advocacy of TIPS as a way to encourage greater use of inflation-protected debt contracts in the private sector. I will go read about the Unidad de Fomento.

It's best to consider all benefits and costs in society, not just to one party, like the government.

I've long wondered, and commented, why doesn't the government issue, way, way more TIPs, which are currently shallowly marketed.

No one is anywhere close to as good as the US government at providing insurance. No private company can have close to the dependability of payment (Even if the historically shameful Republican Party causes a default, the public will make sure all debts with interest are paid in the end.), especially over the very long term, and the US government can have amazingly greater economies of scale and simplicity, without the potentially severe problems of private monopoly power. Their transactions, administrative, and marketing costs can be amazingly lower.

So, you really want the US government to do a large amount of insurance, i.e. Social Security's advantages over private comapanies' pension schemes, or at least as a big addition to them, Medicare and Medicaid versus private insurance, and so on.

Insuring against inflation risk is a big deal. And no private company can do that like the US government. So why aren't they doing it in a huge way? A transfer of risk from a single vulnerable individual to the gargantuan, intergenerational, US federal government pool? Obviously, very smart, efficient, and increasing of total societal utils.

But right now TIPS are shallow and hard for the common person to buy. – Let's not just expand them, but make them easy to purchase in realtively small standardized increments and durations from any starting day.

Right now it looks like the government is making out big time with near zero, or even negative real yields, because they issue so few they can sell to just the small clientele of ultra risk averse and inflation scared.

Richard, I agree with a lot of these points, and plan to write about related issues in future posts in this series. As I said in last paragraph, "The government's borrowing cost is not the only factor to consider when evaluating the net effect of TIPS."

".You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

"In short, the inflation risk premium does not depend directly on how uncertain or volatile inflation is. What matters for the inflation risk premium is how future inflation covaries with future consumption (alternatively, with the stock market), and that is not obvious."

This is a great example of overliteral interpretation from a model to reality.

White idiosyncratic risk does not add to an individual's risk IF it can be combined with a gigantic amount of other uncorrelated idiosyncratic risks in a pooled and scaled down way.

But, so often in reality there's no practical way to diversify away all the idiosyncratic risk, or come close. So, in the real world, completely idiosyncratic risk is often a big deal.

Individuals need be very scared of idiosyncratic risk, because very often they won't be able to easily pool it away with a bazillion other uncorrelated idiosyncratic risks.

If someone offered you a coin flip, heads get $2 million, tails pay $2 million, that you can make payments on your whole life, or a risk free bond that paid zero, cost zero, would you consider them equivalent because they have the same expected return and they're both "risk free"?

I don't think so. You might say, I'll sell my coin flip in tiny pieces, but could you imagine the time and transactions costs of doing that.

Idiosyncratic risk is only always costless in models, and a model is only as good as its interpretation. Beware of overliteral interpretation.

Isn't the coin flip example even less reality-based than the model? If you could buy the heads get $2 million, tails pay $2 million asset, why couldn't you also buy a tails get $2 million, heads pay $2 million asset? Then yes, I would consider equivalent to the risk free bond that paid zero, cost zero. The TIPS you can buy in smaller denominations than millions of dollars.

You have answered your own question: this contract does not exist and the reason is that the price to buy heads must be the same as the price to buy tails. On the other hand, I can always exchange a dollar for a dollar.

When an investor is assumed to make investments that are "significant" compared to her wealth, this is not a question of risk aversion. The fraction of wealth invested by a risk-neutral investor who wishes to maximize her expected return depends on the volatility as well as the ensemble expectation of return; see http://en.wikipedia.org/wiki/Kelly_criterion.

A main point is in a model it's often easy and costless to 100% diversify away uncorrelated, white, idiosyncratic risk, so it's considered riskless. But if you take that interpretation literally to the real world, you can make some very bad decisions and policies. It is, for example, well known that ideosyncratic risk can be far from costless to a firm, at least due to financial distress costs.

The problem is not necessarily in a model's unrealism, or an example's, it's the interpretation of that model or example to reality. Paul Krugman had some famously unrealistic models, but the lessons he drew, the interpretation to reality, took into account the unrealism. He was not overly literal.

Even if inflation were found to be 100% uncorrelated with the stock market, and an individual's personal consumption or income, it's still going to be very risky inflation-wise for an individual to put 30%, 50% of his income into long term fixed bonds, and he might have good reason to want something like that. This is because even if inflation is 100% idiosyncratic risk, there's no good way to diversify it away in the real world.

You could combine a tiny bit of money in a nominal fixed government bond with 5,000 stocks on the exchanges, pooling with their idiosyncratic risks, but then only 1/5000th of your money is approximately risk-free, and it might be better for you to have 1/5th be that way.

There could be some derivative on just the inflation risk part of a US government bond sold throughout the economy, and you could use that to insure your bond, but transactions costs, fitting, inconvienence, gaming, the government having to in the end back contracts,... A lot can be a problem compared to simple, clean, convenient widely available TIPS.

1) The equity premium puzzle – While I certainly like TIPS, in some proportion, for some people, the difference in expected real return between TIPS and stocks (and good expert real estate investment, if you have the expertise to do it well) is just so huge!! And stocks hedge nicely against inflation. It's really hard to get that enthused about TIPS. I have a short explanation, not seen, on why we can expect this to persist, at:

http://works.bepress.com/richard_serlin/18/

2) It's interesting to ask what TIPS can do that just rolling over 3 month treasuries can't. First, with a 20 year TIPS you eliminate CPI risk, but also lock in risklessly the real rate. With rolling over T-Bills, you still risk the real rate dropping and hurting your quality of life. Second, there's still some CPI risk with 3 month T-Bills for the 3 months you're locked in. Third, transactions costs are lower and convenience higher with the TIPS, even compared to a money market fund.

One assumes that the savings are invested in productivity enhancing projects (bridges, big computers, scientific research etc). Most any project is probably better than stuffing cash in a mattress - so in general the assumption is at least somewhat true, even if non-trivial.

So if I understand this correctly, much of the debate hinges on estimates of inflation risk premium. But is looking at just the difference in risk premium the whole story? After all, if government issues TIPS, it may find buyers willing to lend at lower yields, but at the same time exposes itself to the inflation risk.

Or from a different point of view, Modigliani-Miller result tells us that (under highly idealized assumptions) it's irrelevant whether a firm is financed by equity or debt. Shouldn't similar logic apply (in some way) also to the government?

Interesting point. Perhaps exposure to inflation risk isn't as costly for the government (after all, they have a ton of nominal debt, whereas people who buy TIPS may already have a lot of nominal assets). And the government has at least some influence on the inflation rate. I haven't thought this through all the way and hope some other commenters will chime in.

The government taxes a percentage of income and thus its income is in real dollars. Issuing inflation-linked liabilities therefore matches assets to liabilities.

It of course remains true that by issuing TIPS the government forgoes the option to default on its debt by inflation. But if that option has a price, shouldn't it be reflected in the prices of real and nominal bonds? Like any other embedded option?

Not even a mention of the Cleveland Fed's ongoing estimates of inflation expectations? The Chopped Liver Fed, I guess.

"... the bulk of that cost a direct result of significantly higher inflation than estimated by the markets 'breakeven' level when issued."

This reasoning is bizarre. Do they advocate funding the government entirely on 3M nominal bills, on the grounds that realized interest rates are systematically less than those implied by 30Y bond yields?

Thank you for the series! This is something I really wanted to learn about.

What I am wondering is if its possible to use indexed bonds in developing countries as a way to increase anti-inflation credibility (and develop their domestic savings)?

This is a separate discussion - developing countries have either severe inflation or pay a great price for lowering it.

If you can impose fiscal restraint without a monetary and exchange policy straight-jacket, this can be an end to the endless currency crises controversies and a new role for organizations like the IMF (it can offer loans only to countries that emit indexed bonds, or maybe it can do a Brady-bond-type swap with indexed bonds).

Another aspect is that the presence of TIPS provides a signal that the treasury/Fed have a financing cost incentive to keep inflation low. I would surmise that the presence of TIPS has helped keep nominal yields low by providing the market at least the the appearance of an alignment of investor and issuer interests, which would otherwise be contradictory.